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The Role of Endogenous Uncertainty in the Forward Discount Bias

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  • Stanley Wilkes Black

    () (Dimensional Fund Advisors LP, USA)

Abstract

This study examines what role the concept of endogenous uncertainty can have in explaining a phenomenon of international financial markets, the forward discount bias. The forward discount bias puzzle is unexplained by models assuming economic agents have full knowledge of the structure of the economy. This puzzle is explained here by constructing an overlapping generations model of a Rational Belief Equilibrium in a non-stationary environment where agents do not know the true probability distribution underlying asset price movements. The agents’ beliefs are rational in the sense that their predictions of long term averages of economic variables match historical data. The equilibrium of the model is solved numerically using the nonlinear equation solver TENSOLVE, which is well-suited to models containing multiple financial assets. The results confirm the underlying hypothesis that propagation of the beliefs of economic agents can play an important role in understanding international financial markets

Suggested Citation

  • Stanley Wilkes Black, 2007. "The Role of Endogenous Uncertainty in the Forward Discount Bias," Rivista Internazionale di Scienze Sociali, Vita e Pensiero, Pubblicazioni dell'Universita' Cattolica del Sacro Cuore, vol. 115(3), pages 327-364.
  • Handle: RePEc:vep:journl:y:2007:v:115:i:3:p:327-364
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    References listed on IDEAS

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    1. William Easterly, 2002. "The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262550423, January.
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    8. World Bank & International Monetory Fund, 2001. "Developing Government Bond Markets : A Handbook," World Bank Publications, The World Bank, number 13865.
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    More about this item

    Keywords

    forward bias; forward discount bias; uncovered interest parity; exchange rates; market volatility; expectations; Rational Beliefs; heterogeneous beliefs; optimism;

    JEL classification:

    • F3 - International Economics - - International Finance
    • D5 - Microeconomics - - General Equilibrium and Disequilibrium
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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